Tax and House Prices

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would change both house prices and rents, and it is hard topredict which would move most. We have assumed that one-third of the adjustment to a tax change would come about viahigher rents, and two-thirds of the adjustment would come vialower house prices. On a similar note, we have assumed that thetax changes will be revenue neutral and will not change averageafter-tax incomes. We take no stance of any pre-existing over- orunder-valuation of housing, since we are estimating changes infair value. Still, the framework is useful for illustrating that priceswill be affected by taxes, and for giving a rough guideline as tomagnitude.

Possible tax changes and their impact

Top rate of income tax reduced to 30%

Impact on house prices: -13.6%

Impact on rents: +6.8%

New rental yield: 5.7%

Effect on rate of homeownership: Higher

Landlords receive a tax rebate for losses on their rental propertiesat their marginal rate of income tax . If the marginal rate ofincome tax changes, so does the size of the rebate. For example,consider a landlord who is taxed at 38% and loses $20,000 perannum from owning a rental property. At present, s/he gets arebate of $7,200 each year (0.38x$20,000). If the top rate ofincome tax were 30%, the rebate would be just $6,000 per year(0.3*$20,000). The annual net cost of becoming a leveragedlandlord would instantly increase by $1,200, so fewer peoplewould be willing to do it. Less demand would cause house pricesto fall. Fewer willing landlords would mean higher rents. Lowerhouse prices and higher rents would make home ownership bothmore attractive and more affordable, so home ownership wouldbe higher than if taxes remained unchanged.

Leveraged landlords are the marginal buyer in most segmentsof the New Zealand housing market, so they determine the price.However, it is useful to note that a change in income tax wouldalso affect debt-free owner occupiers. Lower income tax meansless tax on interest income or dividends. This would increase the

Tax and house pricesChanges to the tax system are likely to reduce house values

16 December 2009

In New Zealand, owning property comes with tax advantages.An investment in ones own home incurs zero tax on the flow ofbenefits (avoiding rent and capital gain). By contrast, all otherinvestments incur tax on the interest/dividends/profits. Owningrental property can be useful from a tax perspective, too.Landlords normally pay more in expenses and mortgage interestthan they receive in rent. These losses are tax deductible againstother income, while capital gains are tax free.1 High-incomelandlords can swap their taxable labour income for tax-freecapital gain income. Unsurprisingly, many do. Ownership ofNew Zealand rental properties is skewed towards high incomeworking-age people, and the sector as a whole claims more in

tax deductions than it pays in tax.2

The price of a property both owner occupied and rental partly reflects the tax benefits conferred upon the owner. Ifthe tax benefit changes, so will the price. This bulletin uses ourInvestment Value of Housing model to estimate the impact ofpotential changes to the tax system on house prices. We alsodiscuss possible impacts on the rate of home ownership (the taxsystem currently discourages home ownership because landlordsare treated more favourably than indebted owner occupiers). Wehave focussed roughly on the tax changes being discussed by theTax Working Group (TWG,www.victoria.ac.nz/sacl/cagtr/twg).

The estimates relate to a median property in New Zealand,currently worth $350,000 and being rented out for $310per week, for a gross rental yield of 4.6%. Of course, theestimates are ball-park figures only, and are sensitive to theassumptions made (detailed in Table 1). For example, tax reform

Potential changes to the tax system could reducehouse prices.

We estimate that changing the top rate of income taxto 30% would reduce house prices by 14%.

Many of the potential tax changes could increase therate of home ownership.

For all clients: Westpac Institutional Bank is a division of Westpac Banking Corporation ABN 33 007 457 141, incorporated in Australia (Westpac). The information contained in this report: does not constitute an offer,

or a solicitation of an offer, to subscribe for or purchase any securities or other financial instrument; does not constitute an offer, inducement or solicitation to enter a legally binding contract; and is not to be construedas an indication or prediction of future results. The information is general and preliminary information only and while Westpac has made every effort to ensure that information is free from error, Westpac does notwarrant the accuracy, adequacy or completeness of the Information. The Information may contain material provided directly by third parties and while such material is published with necessary permission, Westpacaccepts no responsibility for the accuracy or completeness of any such material. In preparing the Information, Westpac has not taken into consideration the financial situation, investment objectives or particular needsof any particular investor and recommends that investors seek independent advice before acting on the Information. Certain types of transactions, including those involving futures, options and high yield securities giverise to substantial risk and are not suitable for all investors. Except where contrary to law, Westpac intends by this notice to exclude liability for the information. The information is subject to change without notice.Westpac expressly prohibits you from passing on this document to any third party. Westpac Banking Corporation is regulated for the conduct of investment business in the United Kingdom by the Financial ServicesAuthority. 2001For Australian clients: WARNING This document is provided to you solely for your own use and in your capacity as a wholesale client of Westpac.

For further information, questions or comments contact Brendan ODonovan, telephone (04) 470 8250, email [email protected]

1 Except in rare cases when the Inland Revenue Department can prove that theinvestor purchased the property with the intention of realising capital gain.2 For ownership breakdown, see http://www.victoria.ac.nz/sacl/cagtr/twg/Publications/3-taxation-of-capital-gains-ird_treasury.pdf
http://www.victoria.ac.nz/sacl/cagtr/twghttp://www.victoria.ac.nz/sacl/cagtr/twg/Publications/3-taxation-of-capital-gains-ird_treasury.pdfhttp://www.victoria.ac.nz/sacl/cagtr/twg/Publications/3-taxation-of-capital-gains-ird_treasury.pdfhttp://www.victoria.ac.nz/sacl/cagtr/twg/Publications/3-taxation-of-capital-gains-ird_treasury.pdfhttp://www.victoria.ac.nz/sacl/cagtr/twg/Publications/3-taxation-of-capital-gains-ird_treasury.pdfhttp://www.victoria.ac.nz/sacl/cagtr/twg


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Deemed rate of return (tax applied on 6% of equity)

Impact on house prices: Between -26% and -34%

Impact on rents: Between +13% and +17%

New rental yield: 7.0% to 8.2%Effect on rate of homeownership: Higher

For property investors, rental income would not be taxed, andexpenses (including interest) would not be tax deductible.Instead, income tax would be applied to a deemed rate ofreturn on the net equity in the property. Owner-occupierswould be unaffected. The TWG discussed a deemed rate ofreturn of 6%.

Fully leveraged landlords would not pay any tax on their zeroequity, but they would lose the right to deduct cash losses on theproperty against their taxable income. That would make rentalproperty worth 34% less to 100% leveraged landlords.

Debt-free landlords would face a higher tax bill than theyface today, causing a 26% fall in the net present value ofrental property for them. Since debt-free landlords would beless impacted than leveraged landlords, there would be sometransfer in ownership. Depending on the willingness of lessleveraged investors to enter the market, the price decline wouldbe between 26% and 34%.

Market segments in which investors are less prevalent, such asthe top end, might be less affected by this tax, although theimpact would not be zero.

Ringfencing

Impact on house prices: Down

Impact on rents: Up


Rental losses could only be offset against future rental profits,not current personal income. There would no ability to shelterfrom income tax using loss-making rental properties. However,property would still be a tax-efficient investment for cash-flowpositive landlords. Many leveraged landlords would either paydown debt or sell to cash-flow positive landlords. Prices wouldfall, but it is not possible to predict how far.

Land tax 0.5% and income tax 30%





This scenario is politically plausible.

incentive to save via bank deposits, shares, or business ownershiprather than by owning a bigger/better house. So demand forproperty would fall.

Land Tax 0.5%




Effect on rate of homeownership: Neutral or down, depending on design

Impact on price of land: -11%

A land tax would be levied on the owners of land, and calculatedas a percentage of the unimproved value of land as determinedby the rating valuation similar to rates but applied to land

value, not capital value. We estimate that the value of landwould fall by 11%. Our estimate of a 4.4% house price declineapplies to the median New Zealand house, for which landmakes up 40% of the value. Properties for which land makesup a greater proportion of the value, such as lifestyle blocks,would experience a greater percentage decline in overall price.Apartments would experience a smaller percentage decline.

The impact on home ownership depends on the detail of the tax.We have assumed that the land tax is treated as a tax-deductibleexpense for landlords. (IRD argued at the TWG that failure todo so would create distortions). If the land tax were not taxdeductible for owner occupiers, then landlords would enjoy aneven greater tax advantage over leveraged owner occupiers,and therefore home ownership would fall. One way aroundthis would be to simply set the tax at a lower rate for owner-occupiers.

Capital Gains Tax 10%





The TWG discussed the possibility of a capital gains tax thatwould exempt the family home, but would apply to rentalproperties. Such a tax would reduce the tax advantage of owningrental property, and would therefore dramatically reduce theprice of property. A capital gains tax would remove the taxsubsidy for landlords, so rents would rise. Lower house prices andhigher rent would mean higher home ownership.

Top-end property would be less affected than lower-end ones, soprice dispersion would widen.

We regard capital gains tax on investment property as unlikelyto happen. For a start, it would be complex to administer. Worse,much of the burden would fall on tenants, who tend to have lowincomes.


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The impact of tax changes on P were determined by varyingt 1, t 2,or l, and simultaneously assuming that the percentage change inR is equal to half of the percentage change in P. The deemed rateof return scenario involved settingt 1 = t 2 = l = 0. For the land taxscenarios,l was set at 0.2%

There are a number of deeper assumptions underlying thismodel:

Rent and maintenance costs are assumed to grow at thesame average rate as house prices in equilibrium.

We have ignored second-round effects stemming from thelikes of a change in disposable income after a tax change.This is unlikely to be a large problem if the tax changes arerevenue neutral.

The tax changes are assumed to be completely unanticipated.

If they were anticipated, the actual price change would besmaller than our estimate.

We treat 100% leveraged investors as the marginal buyer,implying that they determine the price. That is a reasonableapproximation for most market segments except the very topend. Houses are worth most to debt-free owner-occupiers,but not every person has sufficient capital to fit into thatcategory. Houses not already taken by the debt-free owneroccupiers are worth most to investors, because they getbetter tax breaks than owner occupiers with high debt. Theamount that a 100% leveraged investor on the 38% tax rateis willing to pay for a property sets a price floor at auction,

so long as sufficient capital is available. Anybody who wantsto own a property must bid at least the price floor set by theInvestment Value. The fact that many properties are actuallyowned by leveraged investors suggests that property doesnot trade at a premium to that floor (owner occupiers donot need to pay much more than the floor to secure theproperty).

We have estimated the impact of tax changes on theunderlying value of property, abstracting from any pre-existing overvaluation or undervaluation. A view that NZproperty is currently overvalued could be expressed bysetting higher. This changes the estimated impact of tax

changes only slightly.

Brendan ODonovan, Chief Economist, Ph: (64-4) 470 8250Dominick Stephens, Research Economist, Ph: (64-4) 381 1414

What improvement in sustainable capital gain would offsetthe tax changes?If New Zealands sustainable rate of economic growth wereto rise, it is reasonable to assume that the sustainable rate ofcapital gain on housing would increase. (A rule-of-thumb saysthat the real capital gain on land should, on average over time,equal real economic growth).

Our baseline scenario assumes 2.5% sustainable real capitalgain. To completely offset the price-negative impact of the taxchanges in the combined land and income tax scenario, therate of sustainable real capital gain would need to lift to 3.1%,assuming no change in average mortgage rates. We think thatsa bit of a stretch.

The detailsThe calculations use our Investment Value of Housing model,3

which values the property for a 100% leveraged investor (themarginal buyer), using the net present value method. Equilibriumbetween rents and house prices requires that the benefit ofowning a rental property (rent and capital gain after taxes) mustequal the cost of owning a rental property (interest, maintenance,and land taxes after tax deductions, plus compensation for risk):

R(1- t 1) + P( e + g)(1- t 2) = P( i)(1- t 1) + ( f )(1- t 1) + P( l)(1- t 1) + P( )

Definitions are outlined in Table 1 below, along with the assumedvalues. The equation above can be solved for price to give theInvestment Value of Housing:

(R- f )(1- t 1)P =

(i+l)(1- t 1) ( e+g)(1- t 2) +

Table 1: Definitions

Symbol VariableValue in

base caseReason

P Price $350,000Approximate value of median house in NewZealand, Nov 2009.

R Annual rent $16,120Ministry of Housing median rent on 3-bedroom house is $310 per week.

f Cost of maintaining theproperty

$9,000$7,700 for upkeep, rates, and insurance,$1,300 for property management

i Interest rate 8%Two-year mortgage rates averaged 8.16%from Jan 1995 to today.

eLong-run expected rateof inflation

2.50%Current 2-year ahead inflation expectations2.6%. 5-year average inflation 3.0%. RBNZinflation target 1% - 3%, with history ofpreferring top part of target range.

gExpected long-runsustainable rate of realcapital gain

2.50%Compound average annual rate 1970 totoday 2.57%.

Risk premium 1.30%Calibrated to force investor value equal to$350,000.

t 1Marginal rate ofincome tax

38%Taxpayers on the 38% rate have the most togain from owning rental property, and arethe most likely to own rental property.

l Rate of property tax 0%

t 2Rate of capital gainstax

0%

3 The Investment Value of Housing model is based on the User Cost of Housing usedby, for example, Poterba, J (1992),Taxation and housing: old questions, new answers ,American Economic Review, 82, 2, pp 237-242. We adapted the model to betterreect the New Zealands tax system for our 2007 BulletinBubble Schmubble .The model was also used by Hargreaves (2008)The tax system and housing demand in New Zealand , RBNZ Discussion Paper DP 2008/06. All of these earlier modelstreated maintenance costs as a proportion of the houses value, which implies thatwhen property prices fall as a consequence of a tax change, the cost of maintaining

the house also falls. This is unrealistic and causes understatement of tax impactson prices. Our current model treats maintenance costs as independent of houseprices. Previous models also lumped the risk premium in with maintenance costs,which made it tax deductible and therefore exaggerated the impact of tax changeson prices. We have corrected that error in the present model.

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Tax and House Prices